How to finance growth for Small & Medium sized Enterprises?

When the sample of more than 9,500 publicly traded companies is grouped according to size of sales, the picture displayed is very similar to the one where market caps were used as the categorisation – smaller companies, whether categorised after sales size or market cap, have a lower return and as the graph on the right displays, the return increases with size.

The graph also displays the clear correlation between ROCE and NWC/Sales, the lower NWC/ Sales companies show the higher ROCE it yields. Returns for companies in the range <50m to EUR 100m is below 4% in return whereas the NWC/Sales is above 17%.

As displayed in the graph to the right, except for the absolute smallest category (<50m) the 50m-100m and 100m – 500m display high growth, at a median of approximately 6 and 8% respectively. In order to fund growth, companies require capital, preferably from self-generated cash flow or secondly, from an external source, e.g., debt funding or as an equity injection.

We have previously seen that smaller companies yield lower returns and are less efficient in their use of working capital. That is not good for the self-generated / operating cash flow. At the same time smaller companies, as displayed in the graph, have very moderate leverage, displaying a problem for smaller companies to obtain external financing. The last solution for cash for many smaller companies seems to be obtaining equity injections from their owners, but in many cases companies, or the management of the companies, hesitate to ask their owners for continuous equity injections.

The data in this report is on publicly traded companies, whereas the vast majority of SMEs are privately owned companies. For private owned companies, the possibility to obtain capital are in many cases even more slim than for the publicly traded ones, with the effect of capital and financing being an even scarcer resource.

The graph to the right displays a summarised view of a fictive company’s in- and outflow of cash over the course of a year, the “Sources and Uses of cash”. The column on the left hand side in the graph depicts the “Sources of cash” a company can attain. In this example the operating cash flow part is the largest source of cash (cash generated by the company within its business operations). The other two sources that might be available for companies are Debt issuance (loans from banks) and Equity injections (funds from owner/s). On the right hand side, the column depicts the “Uses” of cash, where in this example the largest use of cash is for Capex (capital expenditure).

The key thing here is of course that both sides shall be of the same sizes / amounts, the two columns should add up. If, for example, “Uses” are higher than “Sources”, then the company has a problem as the company will run into a shortage of cash. Then some things need to be sacrificed. The company may not be able to do the amount of Capex required to increase production, or maybe the company needs to sacrifice a new deal with a customer due to long payment terms, and with shortage of cash, they can’t afford to wait for payment.

For companies, the ability to raise capital is key to bridging gaps between in- and outflows of cash and to making the necessary capital expenditure and investments. For companies where capital and cash is too of a scarce resource the company’s ability to seize business opportunities and grow might be hampered.

The Swedish Federation of Business Owners (Företagarna in Swedish) is the largest business organisation in Sweden representing the interests of around 60,000 business owners. In its yearly report concerning companies’ prospect of raising financing the organisation points out that raising financing is one of the greatest challenges for growing companies and for investments¹.

The graph on the right-hand side is taken from the same report and it depicts that 68% of companies that had made an investment during the last 12 months found difficulties in raising bank financing (where 24% found it “Very difficult” and 44% “Rather difficult”). The number has increased steeply since 2019 which probably is caused by the uncertainty in the business environment following the Covid-19 pandemic. The long trend is also that companies perceive it to become more difficult and the probable explanation is that banks have been, and continuously are, imposed by higher capital requirements and thereby requiring more securities to offer bank loans². The same concerns are raised in other Nordic countries and organisations, e.g., in Denmark by The Danish Construction Association (Dansk Byggeri in Danish) in its yearly report “The economic environment barometer”³.

Another Swedish organisation for companies, the Confederation of Swedish Enterprise (Svenskt Näringsliv in Swedish), points out Small and Medium sized companies (SMEs) within Trade and Manufacturing industries as the two industries who are probably affected most negatively and hence having most difficulties in raising bank financing. A reason for this is according to the report that companies within these industries have less ability to raise financing without having any strong collateral. With no strong collateral banks might consider these SMEs too risky and therefore non-bankable⁴.

All is not lost! The organisations above propose a couple of solutions in order to make it easier to raise financing for SMEs. Two suggestions that we found the most interesting are “Alternative fintech solutions” and “Shortened payment terms” from customers.

Legislating about shortened payment terms might be a great solution at first sight and especially when looking at the graph to the right which shows that payment terms from customers to smaller companies are longer than for larger companies. But in practice it is more complicated as companies operate in a competitive environment and payment terms is a term and condition up for business negotiation, same as for price and other conditions. It should also be taken into consideration that many companies operate on an international market and that payment terms differ significantly in various parts of the world.

The reason for selecting the suggestions of “Alternative fintech solutions” and “Shortened payment terms” is of the possibility of today to combine the two for a viable and practical solution for companies to run operations in a more capital efficient manner and in order to improve operating cash flow in “Sources and Uses”. By doing this a company can improve its self-financing. This would in turn make the company less dependent on external financing for its daily operations and enable cash release, which can be used for e.g., growth, capex and investments.

A third alternative for SMEs, with an exporting feature in its business, to raise necessary capital is with a credit guarantee, where a bank shares the risk with a domestic state owned Export Credit Agency (ECA) (EKF in Denmark, Finnvera in Finland, GIEK in Norway and EKN in Sweden). The Nordic ECAs can cover a percentage of the risk and thereby making it more attractive for a bank to lend out money to a company. The support and risk coverage the Nordic ECAs can offer differs between the four Nordic ECAs, but all include risk coverage which enables banks to provide companies with the possibility for invoice discounting and / or to set-up an overdraft facility.